Understanding the convertible note term sheet

Love them or hate them, convertible notes have become an often-used tool for early stage corporate financing.

In general terms, a convertible note is an unsecured loan which has the option to “convert” into ownership of a company months or years later, once the loan matures. Such a loan provides a runway for a company to produce a viable and hopefully profitable product or service, and then secure higher levels of investment (sometimes referred to as a “preferred financing”) in order to scale .

Prior to the convertible note financing, it is common for the company and a convertible note investor to finalize a “term sheet.” A term sheet is a short document that outlines in broad strokes the terms of investment. Once the term sheet is agreed to, a much larger convertible note purchase agreement can be drafted and signed.

How much interest will the notes bear? The interest rate is important, as the interest will be added to the original amount of financing for purposes of providing equity to the investor if and when the note converts. The interest rate is negotiable between the company and the investor.

How will the note convert?Usually, a convertible note will automatically convert in the event of a large scale investment round by another round of investors. But what counts as “large scale”? This is worth an honest discussion between the investor and the company as to the company’s long term vision and future. While no one can predict the future, there are some companies that wish to stay small and nimble (and profitable), and there are other companies that have visions of grandeur. The convertible note investor and the company should be on the same page with respect to that vision. That vision, in turn, will produce the appropriate figure with respect to conversion.

Is there a voluntary conversion? Companies might want to have a voluntary conversion term which will permit the company, at its option, to convert the investment into shares of the company once the note matures, instead of paying back the loan. An investor may not like this approach, or may want to control any terms of voluntary conversion.

What happens if the company is sold? Language with respect to “change of control” is fairly standard, and usually grants the investor the option to elect payment on the loan, or to convert into equity immediately prior to the buy-out so that the investor can be paid for his or her shares at the buy-out price.

While there are a variety of ways to structure a convertible note, the key thing in drafting any term sheet should be a shared vision between the company and its investors. An open and honest discussion regarding this long term vision and strategy will go a long way in aligning the interests of the company and the investors with respect to terms